Investing At The Point Of Maximum Fear, Part 2

As mentioned in the first part of this article, most investors would like to invest in premium companies with a great history record but they cannot find a bargain entry price because these companies always trade at a significant premium. Good entry points usually show up in periods of recession but in such periods the premium stocks usually decline much less than the majority of the stocks and hence investors prefer buying other stocks, which seem a much greater bargain.

Therefore, the only time an investor can buy a premium stock at a significant discount is when the company faces a headwind that is particular to the company. Surprisingly, even in such cases, most investors don't dare to buy the premium stock, as it takes great determination to be a contrarian when there is "blood in the streets". In this article, I will add some premium companies that recently offered the investors an exceptional bargain price.

Moody's

Last month the Department of Justice (DOJ) sought a compensation of $5 B from S&P (MHP), accusing the company of deliberately offering unwarranted AAA ratings to CDOs and companies in order to get business from them in the years before 2008 [1]. A few days later, the DOJ prepared a similar lawsuit for Moody's (NYSE:MCO) as well [2], causing its stock to plunge 20%, from $55 to $44, in just one week. In the thick of hysteria, an analyst claimed that the stock of Moody's could easily go to zero, just like Enron did.

However, an astute investor would not lose faith in such an exceptional company. Moody's has almost tripled its earnings per share (EPS) in the last 9 years and carries a minimal amount of net debt, which can be paid off with just one year's earnings. Moreover, the analysts predict a 15% EPS growth this year and a 10% growth next year (data from finance.yahoo.com).

The company is so confident in predicting its earnings that it has been consistently purchasing its own shares every year and does not mind having a slightly negative book value, which can be easily restored with its future earnings. A proof of the company's solid position is the approval of its new share buyback program of $1 B just a few days after the lawsuit [3]. If the company was in danger, the program would definitely be rejected.

It is remarkable that Warren Buffett maintains a large stake (12.8%) in Moody's while David Einhorn admitted he incurred his greatest loss due to shorting this company. As soon as the noise from the lawsuit settled, the stock rebounded strongly and has already recovered 70% of its losses in just one month. A similar trend was observed in McGraw-Hill, though the decline was steeper (28%) and the recovery has been slower (only half of the loss has been recouped).

McDonald's

McDonald's (NYSE:MCD) reported disappointing results for Q3 about five months ago. Its earnings missed expectations by 3% as its sales exhibited a slowdown and the company admitted that it was not able to pass the higher food cost to its consumers [4]. The reaction of the market was relentless, sending the stock down $10 in one month, from $94 to $84. To realize the magnitude of this decline, one should keep in mind that McDonald's fell only $15 during the great recession of 2008.

Despite the temporary slowdown that may arise once in a while, one should never miss the big picture of McDonald's. The company has increased its EPS by 4.5 times in the last 9 years and even achieved a 10% EPS growth during the great recession. Moreover, it is expected to grow its EPS by 10% annually in the next two years. Furthermore, it has maintained a low amount of net debt, which can be paid off with just 3 years' earnings.

The stock of McDonald's has strongly rebounded since its bottom, gaining 18% in the last four months and approaching its all-time high of $102. In addition, the investors who appreciated the stock at its bottom of $84 are also earning a dividend yield 3.7%.

Western Union

Western Union (NYSE:WU) experienced a crash and fell 30% when its Q3 results disappointed its investors four months ago. It was a great surprise to see that extreme market reaction, as the EPS surpassed expectations by 2% while the revenue missed expectations by 5%. The crash was supposedly due to fears of losing market share (competitor XOOM performed an IPO in February) and lack of transformation to become digital.

However, I believe that Western Union is a value play at the current price of $14.50. The company has thrived for more than 135 years and is active in more than 200 countries. Moreover, Western Union is a consistent buyer of its own stock and has announced a share buyback program of $750 M, which can reduce its outstanding shares by 9%. Even if the company does not grow its earnings in the next few years, it can continue purchasing about 9% of its shares every year, which will greatly increase its stock price eventually.

Coach

The investors of Coach (NYSE:COH) have really had a tough year, as they have lost almost 50% of their shareholder value in the last 12 months. The main reason for the decline was the aggressive growth of the main competitor of Coach, Michael Kors Holdings (NYSE:KORS), which is expected to triple its EPS in just two years.

However, the pronounced decline of Coach is really surprising, as the company markedly increases its EPS every year and is expected to grow further in the future. More specifically, the company has increased its earnings by 7 times in 9 years and, thanks to its share buybacks, it has increased its EPS by 9 times. Moreover, it is expected to grow its EPS by 5% this year and 10% next year while its current P/E ratio is only 13.5, which is extremely low for a growing company. It is also remarkable that the company achieved the above exceptional performance without incurring any debt. Therefore, I expect the stock price of Coach to be a great performer in the next few months.

Conclusion

Investors should be patient and avoid buying overvalued shares, even of great companies, because their portfolio performance will be mediocre due to their poor entry point. I have learnt from experience that even the greatest companies face headwinds at some point and thus offer attractive price levels, which one should be decisive enough to exploit. Nevertheless, a prudent investor should always perform a due diligence to determine whether it is a one-time disaster or a permanent loss of the earning capacity of the company.

Disclosure: I am long WU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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